Skepticism deters sales of annuities

Your Money

November 19, 2006|By Humberto Cruz | Humberto Cruz,Tribune Media Services

Among economists and academics, a consensus is growing that annuitization - exchanging a lump sum of money for a lifetime income stream - can go a long way toward helping provide retirement security for millions of Americans.

But if annuitization is good for us, why do so few of us do it?

This question has been dubbed the "annuity puzzle," and a new study by two college professors explores likely reasons, from cost to mistrust of the insurance industry. The study also examines legislative proposals to encourage annuitization by providing tax incentives for buyers of so-called immediate annuities that pay an income for life.

Consumers have been cool to these annuities, which accounted for less than $12 billion of the more than $212 billion in annuity sales last year. Deferred annuities, in which earnings grow tax-deferred until withdrawn, are more heavily marketed and rack up far more sales. While deferred annuities offer the option to annuitize when you withdraw the money, only a small percentage of buyers do so.

Yet, "economists have long been convinced that annuitization is the way to go" to provide lifetime income security, said William Gentry, associate professor of economics at Williams College and co-author of the study with Casey Rothschild, an assistant professor at Middlebury College.

Perhaps without realizing it, millions of Americans already depend on lifetime annuities for a big chunk of their retirement income. I am talking about Social Security benefits and, for those fortunate enough to have them, defined-benefit pensions that pay a monthly income for life.

When we use the term lifetime annuities, however, we usually mean immediate annuities sold by insurance companies. Although there are many variations, in the typical immediate annuity you pay a lump-sum premium, and in return the insurance company guarantees to pay you, or you and a beneficiary such as a spouse, an income for life.

That leads to a common consumer fear and objection: If you buy an immediate annuity today and die tomorrow, unless you have purchased a minimum number of guaranteed payments, which lowers the monthly income you receive, the insurance company keeps your money, and your heirs don't get a cent.

But if you live years beyond your life expectancy, the insurance company may lose money on you. The insurance company plays the law of averages, relying on life expectancies for people your age and sex and on prevailing interest rates, to determine how much to offer you in exchange for your lump-sum premium. (Based on a recent quote from a major insurer, a 65-year-old man would receive $680 a month for life on a $100,000 premium, and a 65-year-old woman would receive $627. Men receive more because, on average, they die sooner.)

The income you receive, however, is less than what the lump-sum premium would be worth based solely on average life expectancies and prevailing interest rates.

The insurance company has to pay you less to make a profit. Not as obvious, you are paid even less because people who buy immediate annuities tend to be healthier and live longer than the average population, and insurance companies take this into account when setting premiums and payouts.

The result, the professors' study reports, is that many buyers of immediate annuities lose 15 percent to 20 percent of the value of their premiums to hidden costs, or "loads." In general, the older you are when you annuitize, the greater the monthly income you receive but also the more that income is reduced by these invisible loads. In other words, you would have received more money without the insurance costs.

Still, faced with the challenge of managing withdrawals from their retirement nest egg on their own, many retirees would do well to annuitize some of their savings, many independent studies have found.

"Studies clearly show that annuities should be used extensively" to guard against the risk of running out of money in retirement, said Allen Sinai, chief global economist and president of Decision Economics, a research and advisory firm. By including immediate annuities in a diversified portfolio, for example, retirees can afford to invest other assets more aggressively and still make their money last longer.

Gentry and Rothschild analyzed the impact of legislation proposed by Rep. Earl Pomeroy, a North Dakota Democrat, that would exempt from taxes up to $5,000 of lifetime annuity income each year for individuals and $10,000 per couple. They concluded that, by encouraging the purchase of immediate annuities by more people, not just those who expect to live longer, the legislation could reduce insurance costs by 8 percent, providing consumers not only with tax savings but also higher payouts.

Humberto Cruz writes for Tribune Media Services.

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